Watch Out for Earn-Outs in M&A Deals!
Introduction:
Undoubtedly, M&A deals have become common in the business world to expand the market share or to acquire the emerging company. Both the acquiring and target companies reach a consensus on the deal, and the acquisition process begins. However, sometimes things may not go according to plan, and the deal may not satisfy both parties. To deal with such situations, Earn-out comes into the picture where both the parties agree on an earn-out clause to reach maximum satisfaction. But it is not as simple as it sounds. In this blog post, we will explore Earn-outs in detail and why you should be cautious while signing up for it.
What is Earn-out?
Earn-out is a clause where part of the payment is deferred and made based on the target company’s performance after the acquisition. For instance, if the target company’s performance improves after the acquisition, the acquirer company is obligated to pay a higher sum. Earn-out can be favourable to both buyers and sellers since the target company’s past performance represents its ability to continue operating successfully after the acquisition.
Types of Earn-outs
There are mainly two types of Earn-outs: Financial earn-outs and Strategic earn-outs. Financial earn-out is related to gross profits or total revenue generated by the target company after the acquisition. Strategic earn-out focuses on achieving the goals or milestones set by the acquirer company to improve the target company’s performance.
Benefits of Earn-outs
Earn-outs can be beneficial for both the acquirer and target companies. The main benefits of earn-outs are risk-sharing, alignment of interest, acquisition financing assistance, and motivational aid to the target company’s management.
Pitfalls of Earn-outs
Despite the perceived benefits, earn-outs do have some pitfalls, including the risk of the target company’s performance decline post-acquisition, disputes over interpretation, and operational issues.
The Importance of Clear Language
The earn-out clause must be adequately documented and clearly outlined to ensure there is no misinterpretation of the terms. The use of imprecise terminology can lead to confusion and disputes, and it’s imperative the language is clear, concise and mutually understood by all parties involved.
When is Earn-out Appropriate?
Earn-out becomes appropriate in cases where the acquiring company is unable to evaluate the target company’s future performance appropriately or doubts the target company’s performance ability to continue. An Earn-out acts as an incentive to improve performance.
How to Avoid Issues with Earn-outs?
To avoid issues with Earn-outs, the acquisition team should perform adequate due diligence before beginning the M&A process. Sufficient documentation of the deal should be done to ensure transparency between both the companies.
Conclusion
Earn-outs have their advantages and disadvantages to both the acquiring and target companies. Before entering into an Earn-out clause, both parties should consider the risks and benefits. It is essential to ensure both parties have communicated effectively, and the earn-out has been adequately documented. Earn-outs are not suitable for every M&A transaction and should be considered with caution.
FAQs
Q1. In M&A deals, when have Earn-outs gained popularity?
Earn-outs gained popularity in M&A deals after the Financial crisis in 2008 as businesses sought strategies to reduce financial risk.
Q2. How long should an Earn-out period last?
Earn-out period varies based on the nature and structure of the deal. Usually, the duration varies from six months to five years.
Q3. Can Earn-outs worsen seller-takeover conditions in M&As?
Yes, earn-outs can worsen the seller-takeover condition in M&A deals since the sellers get paid based on post-deal performance.
Q4. Can contingencies be included in an Earn-out arrangement?
Yes, the parties may include contingencies in the earn-out arrangement, such as customer satisfaction targets, operating covenants, and relevant personnel retention.
Q5. Can Earn-outs increase uncertainty and risk for the seller?
Yes, earn-outs can increase the seller’s uncertainty and risk since they are paid based on post-deal performance rather than receiving a lump sum during the deal.